The Basics of Fundamental Analysis

Fundamental Analysis Definition

Fundamental analysis is a stock valuation method that uses
financial
and economic analysis to predict the movement of stock prices.

The fundamental information that is analyzed can include a company's
financial reports, and non-financial information such as estimates of
the growth of demand for products sold by the company, industry
comparisons, and economy-wide changes, changes in government policies
etc..

General Strategy

To a fundamentalist, the market price of a stock tends to move
towards it's “real value” or “intrinsic
value”.
If the “intrinsic/real value” of a stock is above
the
current market price, the investor would purchase the stock because he
knows that the stock price would rise and move towards its
“intrinsic or real value”

If the intrinsic value of a stock was below the market price, the
investor would sell the stock because he knows that the stock price is
going to fall and come closer to its intrinsic value.

All this seems simple. Now the next obvious question is how do you find
out what the intrinsic value of a company is? Once you know this, you
will be able to compare this price to the market price of the company
and decide whether you want to buy it (or sell it if you already own
that stock).

To start finding out the intrinsic value, the fundamentalist analyzer
makes an examination of the current and future overall health of the
economy as a whole.

After you analyzed the overall economy, you have to analyze firm you
are interested in. You should analyze factors that give the firm a
competitive advantage in it’s sector such as management
experience, history of performance, growth potential, low cost
producer, brand name etc. Find out as much as possible about the
company and their products.

Do they have any “core competency” or
“fundamental
strength” that puts them ahead of all the other competing
firms?

What advantage do they have over their competing firms?

Do they have a strong market presence and market share?

Or do they constantly have to employ a large part of their
profits
and resources in marketing and finding new customers and fighting for
market share?

After you understand the company & what they do, how they
relate to
the market and their customers, you will be in a much better position
to decide whether the price of the companies stock is going to go up or
down.

Having understood the basics of fundamental analysis, let us go into
some more details.

When investing in the stocks, we want the price of our stock to rise.
Not only do we want our stock price to rise, we want it to rise FAST!
So the challenge is to figure out: which stock prices are going to rise
fast?

Some stocks are cheap and some are costly. Some are worth Rs.500 and
some are even worth 50paise. But the price of the stock is not
important. The price of the stock does not make a stock good to buy.
What is important is how much the price of the stock is likely to
rise.

If you invest Rs.500 in one stock of Rs.500 and the price goes up to
Rs.540 you will make Rs.40. However, if you invest Rs.500 in a 50paise
stock, you will have 1000 stocks. If the price of the stock goes up
from 50paise to Rs.1, then the Rs.500 you invested is now Rs.1000. You
made a profit of Rs.500.

If you understand this, you can see that the price of the stock is not
important. What is important is the rise in the stock’s
price.
More specifically the “percentage” rise in the
stock price
is important.

If the Rs.500 stock becomes worth Rs.540, then that is a 8% rise. This
8% rise only makes us Rs.40. On the other hand when we invest the same
Rs.500 in the 50paise stock and the stock price goes up to Rs.1, it is
a 100% rise as the stock price has doubled. This 100% rise makes us
Rs.500.

The point is that when picking a company, we are interested in a
company whose stock price will rise by a large percentage.

Please note: Looking at the above paragraphs, it may seem like a good
idea to buy all the really cheap 50paise and Rs.1 stocks hoping that
their price will rise by 100% or more. This sounds good, but it can
also be really really bad some times! These really small stocks are
very volatile and unless you know what you are doing, do NOT get into
them.

However, the point to be noted is that we are interested in stocks that
will have the highest % rise in the stock price. Now the question is,
how do you compare stocks. How do you compare a stock worth Rs.500 to a
stock worth 50paise and figure out which one will have a higher
percentage rise.

How do you compare two companies that are in
different fields
and different industries? How do you know which one is fundamentally
strong and which one is week?

If you try to compare two companies in different industries and
different customers it is like comparing apples and elephants. There is
no way to compare them!

So fundamental analysts use different tools and ratios to
compare
all sorts of companies no matter what business they are in or what they
do!

Next let us get into the tools and ratios that tell us about the
companies and their comparison....